Scot ch02 Im

Instructor’s Manual—Chapter 2
CHAPTER 2
Accounting Under Ideal Conditions
2.1 Overview
2.2 The Present Value Model Under Certainty
2.2.1 Summary
2.3 The Present Value Model Under Uncertainty
2.3.1 Summary
2.4 Reserve Recognition Accounting (RRA)
2.4.1 An Example of RRA
2.4.2 Summary
2.4.3 Critique of RRA
2.4.4 Summary
2.5 Historical Cost Accounting Revisited
2.5.1 Comparison of Different Measurement Bases
2.5.2 Accruals
2.5.3 Summary
2.6 The Non-Existence of True Net Income
2.7 Conclusion to Accounting Under Ideal Conditions
Copyright © 2009 Pearson Education Canada 8

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES
1. To Appreciate the Concept of Ideal Conditions
This concept is drawn on throughout the book. Roughly speaking, by ideal conditions I
mean conditions where future firm cash flows and interest rates are known with
certainty or, if not known with certainty, where there is a complete and publicly known
set of states of nature and associated objective probabilities which enables a
completely relevant and reliable expected present value of the firm to be calculated.
I assume risk-neutral investors in this Chapter, so that valuation of the firm is on the
basis of expected present value, that is, no adjustment for risk is needed. The concept
of a risk-averse investor is introduced in Section 3.4, and a capital asset pricing model
of the firm’s shares is described in Section 4.5.
2. To Use the Present Value Model Under Ideal Conditions to Prepare an

Articulated Set of Financial Statements for a Simple Firm
The text limits itself to financial statements for the first year of operations. The problem
material extends the accounting to a subsequent year (see problems 1, 2, 3, 4, 5, and
14). In subsequent years, the firm earns interest on opening cash balance. This is
picked up by the accretion of discount calculation, since cash is included in opening
net assets. Interest earned on cash balances leads naturally to the role of dividends in
present-value accounting and the concept of dividend irrelevance.
3. To Critically Evaluate Reserve Recognition Accounting (RRA) as an

Application of the Present Value Model
I usually allow some class time to criticize the assumptions of ideal conditions. Some
students want to “blow off steam” because they perceive these assumptions as quite
strong. I find that RRA is an excellent vehicle both to motivate and critique present
value-based accounting. The fact that it is on line encourages students to take the
present value model seriously, which I emphasize by basing class discussion on an

example of RRA disclosure from an annual report. However, I also emphasize the
point that present value-based accounting products run into severe implementation
problems when the ideal conditions they need do not hold.
I sometimes receive comments that the text over-emphasizes RRA. I find RRA so
helpful to illustrate numerous course concepts that I have resisted such comments.
However, instructors may wish to emphasize that RRA, based on SFAS 69, is relevant
to Canadian oil and gas firms whose shares are traded in the United States. In this
regard, it is worth noting that Suncor Energy Inc., used as the text RRA illustration in
Section 2.4.1, is a Canadian corporation.
Since most large Canadian oil and gas companies report under SFAS 69, I have
retained reporting under this standard in the body of this chapter. However, if more
attention to Canadian oil and gas accounting is desired, instructors may wish to refer
to National Instrument 51-101 of the Canadian Securities Administrators. This
standard is available on the Alberta Securities Commission website. Problem 24 of
this chapter presents an illustration of reporting under National Instrument 51-101.
4. To Interrelate Basic Accounting Concepts
Having worked through a rather “far out” basis of accounting, it is worthwhile to bring
students back to more familiar territory. Thus, I now discuss concepts of relevance
versus reliability, revenue recognition and recognition lag, matching, and accruals.
The discussion takes place within the context of different bases of valuation—cash
basis, historical cost, and current value. This discussion also helps the instructor to
learn more about the students’ background and ability.
Historical cost accounting is presented as a compromise between cash accounting

(high reliability but low relevance) and current value accounting (low reliability but high
relevance). The matching problem of historical cost accounting is illustrated, with
specific reference to amortization and full cost v. successful efforts accounting in oil
and gas.

Full disclosure is viewed as a way to overcome the existence of many different ways
to match cost and revenues, and the relatively low relevance of historical costs. Full
disclosure informs the user which particular allocation basis has been used, and adds
to relevance through supplementary disclosure.
5. To Question the Existence of Net Income as a Well-Defined Economic

Construct
I use the reliability problems of RRA to question the existence of “true” economic
income except under ideal conditions. With the text example, or some other example,
of RRA disclosure in front of us, I ask the students if they would be willing to pay the
RRA value for the proved reserves of an oil and gas company. Discussion usually
brings out a negative response, for reasons such as difficulties in assessing expected
quantities and prices, disagreement with a 10% discount rate, possible inside
information about costs, additional reserves, etc.
I then point out that there are numerous other assets and liabilities for which a quoted
market price does not exist, and argue that information asymmetry is a major reason
why market prices may not exist. The market for used cars and problems surrounding
insurance markets in the presence of adverse selection and moral hazard provide
other examples of “missing” markets.
Having established that, realistically, there are not quoted market prices available for
“everything,” I point out that it is then impossible to fully value a firm on this basis and,
as a result, it is also impossible to measure true economic income. I take a sort of
perverse pleasure in asking those students who are heading for a professional
accounting career if they really want to devote their lives to measuring something
which does not exist. I am careful to end on an upbeat note, however, by pointing out
that lack of a true measure of income means that a large amount of judgement is
required to come up with a useful measure, and that judgement is the basis of a
profession.
I usually do not go further than the above intuitive argument that incomplete markets
are at the heart of problems of income measurement. However, instructors who wish

to dig into incompleteness more deeply and precisely can assign Beaver & Demski’s
“The Nature of Income Measurement” (The Accounting Review, January, 1979).
SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS
1.
P.V. Ltd.
Income Statement for Year 2
Accretion of discount (10% × 286.36) $28.64
P.V. Ltd.
Balance Sheet
As at Time 2
Financial Asset Shareholders’ Equity
Cash $315.00 Opening balance $286.36
Net income 28.64
Capital Asset
Present value 0.00
$315.00 $315.00
Note that cash includes interest at 10% on opening cash balance of $150.
2. Suppose that P.V. Ltd. paid a dividend of $10 at the end of year 1 (any portion
of year 1 net income would do). Then, its year 2 opening net assets are
$276.36, and net income would be:

P.V. Ltd.
Income Statement
For Year 2
Accretion of discount (10% × 276.36) $27.64
P.V.’s balance sheet at time 2 would be:
P.V. Ltd.
Balance Sheet
As at Time 2
Cash: (140 + 14 + 150) $304.00 Opening balance: $276.36
(286.36 - 10.00 dividend)
Capital Asset, at Net income 27.64
Present value 0.00
$304.00 $304.00
Thus, at time 2 the shareholders have:
Cash from dividend $10.00
Interest at 10% on cash dividend, for year 2 1.00
Value of firm per balance sheet 304.00 $315.00

This is the same value as that of the firm at time 2, assuming P.V. Ltd. paid no
dividends (see Question 1). Consequently, the firm’s dividend policy does not
matter to the shareholders under ideal conditions. It may be worth noting that a
crucial requirement here, following from ideal conditions, is that the investors
and the firm both earn interest on financial assets at the same rate.
3. Year 1
At time 0, you know that if the bad economy state is realized, ex post net
income for year 1 will be a loss of $23.97. If the good economy state is realized,
ex post net income will be $76.03. Since the probability of each state is 0.50,
expected net income for year 1, evaluated at time 0, is:
0.50 (-23.97) + 0.50 (76.03)
= -11.98 + 38.01
= $26.03.
This agrees with the direct calculation of accretion of discount for year 1 in
Example 2.2.
Year 2
Assume that you are at time 1, after the state realization for year 1 has been
observed. Suppose the year 1 state realization is bad economy. Then expected
net income for year 2 is accretion of discount on opening net asset value of
$236.36:
236.36 × .10 = 23.64
Note that this amount includes $10 interest on opening cash balance of $100.
Now suppose the state realization for year 1 is good economy. Expected net
income for year 2 then is:
336.36 × .10 = 33.64,

including interest income of $20 on opening cash balance.
Thus expected net income for year 2 is $23.64 or $33.64, depending on which
state is realized in period 1.
The above assumes the year 2 expected net income is calculated after year 1
state realization is observed. The question could also be interpreted as asking
for expected year 2 net income before the state realization is observed at time
1. Then, expected year 2 net income would be, at time 1:
0.50 (23.64) + 0.50 (33.64)
= 11.82 + 16.82
= $28.64
Expected net income is also called accretion of discount because the firm’s
expected future cash flows are one year closer at year end than at the
beginning. Consequently, the opening firm value is rolled forward or “accreted”
at the 10% discount rate used in the present value calculations.
Note: further discussion of accretion of discount would bring out:
The amount of accretion of discount is driven by the principle of arbitrage, and

risk-neutral valuation. Under these conditions, the market will force a beginning
of year valuation of the firm such that the expected net income is 10% of this
value.
To illustrate, the present value of the firm at time 0 is $260.33 and expected net
income is $26.03 for year 1. Similarly, the present value of the firm at time 1 is
$236.36 or $336.36 depending on state realization, and expected net income
for year 2 is $23.64 or $33.64. In each case the market expects the firm to earn
10% on opening value. This 10% of opening value is accretion of discount.
4. The procedure here is similar to that used in Question 2. Assume that the good
economy state is realized for year 1. Assume also that P.V. Ltd. pays a

dividend of, say, $40 at time 1. If the good economy state is also realized in
year 2, P.V.’s year 2 net income will then be:
P.V. Ltd.
Income Statement
For Year 2
(good economy in year 2)
Accretion of discount [(336.36 – 40) ×.10] 29.64
Abnormal earnings, as a result of good state
realization in year 2 (200 – 150) 50.00
Net income year 2 $79.64
P.V.’s balance sheet at the end of year 2 will then be:
P.V. Ltd.
Balance Sheet
As at Time 2
Cash (200 - 40 + 200 + 16) $376.00 Opening balance $336.36
Less: Dividend end
Capital Asset 0.00 of year 1 40.00
$296.36
Add: Net income 79.64
$376.00 $376.00

Thus, at time 2 shareholders have:
Cash from time 1 dividend $40.00
Interest period 2 on time 1 dividend: $40 ×0.10 4.00
Value of firm per balance sheet, time 2 376.00
$420.00
Note: cash balance of $376 assumes no dividend paid for year 2.
If P.V. Ltd. paid no dividend at time 1, the value of the firm at time 2 would be:
Cash: 200 + 200 + 20 $420.00
Capital asset 0.00 $420.00
Thus, the shareholders’ wealth is the same at time 2 whether the firm pays a
year 1 dividend or not.
An identical analysis applies if the low state is realized in year 2. Shareholders’

wealth is $320 at time 2 regardless of whether P.V. Ltd. pays a dividend at time
1.
A similar analysis applies if the low state is realized in period 1.
Therefore, regardless of the state that is realized, shareholders are indifferent

to dividend policy. As long as ideal conditions hold, the introduction of
uncertainty does not invalidate dividend irrelevancy.

5. Cash end Interest on opening Sales
State realization Probability of year 1 cash balance year 2 Total
bad, bad 0.25 100 10 100 210
bad, good 0.25 100 10 200 310
good, bad 0.25 200 20 100 320
good, good 0.25 200 20 200 420
$1,260
Present value, at time 0, of expected liquidating dividend:
0.25
PA0 = × 1,260 = $260.33
1.10 2
Note: This question illustrates another aspect of dividend irrelevancy--given a dividend

policy, the value of the firm is the same whether it is based on dividends or cash flows.
A related illustration is given in the outline of clean surplus theory in Section 6.5.1. The
only difference between that illustration and this question is that here valuation is as at
time 0, whereas in Section 6.5.1 valuation is as at time 1.
6. a. The expected value of a single roll of a fair die is:
1
x= × (1 + 2 + 3 + 4 + 5 + 6) = 3.5
6
b. First, you would have to write down a set of possible states of nature for
the die. One simple possibility would be to define:
State 1: die is fair
State 2: die is not fair.

Then, subjective probabilities of each state need to be assessed, based on any

prior information you have. For example, if the person supplying you with the
die looks suspicious, you might assess the probability of state 2 as 0.50, say. A
problem with this approach, however, is that to calculate the expected value of
a single roll, you need an expected value conditional on state 2, and this
expected value is not defined when the state is simply “not fair.”
A more elaborate alternative would be to formally recognize that the probability

of rolling a 1 can be anything from zero to one inclusive, and similarly for rolling
a 2, 3, . . . , 6, subject to the requirement that the six probabilities sum to one.
Formally, we can regard a state as a 1 × 6 vector
P = [ p1, p2, . . . , p6],
subject to pi ≥ 0
i = 1, 2, . . . , 6
∑ pi = 1
Thus, the set of states consists of all vectors satisfying these requirements. All
vectors except the one with all pi = 1/6 represent a different possible bias.
Next, it is necessary to assess state probabilities. It is by no means obvious

how to do this. You would have to bring to bear any information or subjective
feelings that you may have. Lacking any objective information, one possibility is
to assume that each possible state is equally likely. Then, the expected value of
a single roll is 3.5.
This does not mean that you believe the die is fair, even though this is the
same answer as in part a. Rather, it means that the various possible biases
cancel each other out, since you feel that they are equally likely. Your
uncertainty about the true state of the die suggests that you would be interested
in any information that would help you refine your subjective probability
assessment, which leads to part c.

c. It will never be known with certainty whether the die is fair or not
because luck might influence the outcome of the rolls. However, after a few
rolls you should be able to better predict future rolls. Yes, the four rolls should
affect your belief that the die is fair because you can calculate the average roll,
which is 1/4 (6 + 4 + 1 + 3) = 3.5 here. Since this is exactly the average roll that
would be expected if the die was fair, you would probably increase your belief
that it is fair.
Note: The main purpose of this question is to anticipate what happens when
objective state probabilities are not available, in preparation for the introduction
of decision making under uncertainty in Section 3.3.1. The analogy of this
question is to the problem of subjectively assessing probabilities over the true
state of the firm and of the role of financial statement information in refining
these probabilities. Questions 7, 8, and 9 of this chapter can usefully be
assigned in conjunction with this question. Alternatively, this question could be
assigned as part of Chapter 3.
7. Under ideal conditions of certainty, future cash flows are known by assumption.
Thus estimates are not applicable.
Under ideal conditions of uncertainty, by assumption, there is a complete and

publicly known set of states of nature, known cash flows conditional on each
state, and objective probabilities of those states. Also, the interest rate to be
used for discounting is given. Then, expected present value is a simple
calculation that does not require estimates to prepare.
8. Under non-ideal conditions, it may be difficult to write down a complete set of

states of nature and associated cash flows. Even if these can be written down,
difficulties remain because objective state probabilities are not available. This is
perhaps the most fundamental difficulty, since these probabilities must be
subjectively estimated. This opens them up to reliability problems of bias and
lack of precision. Also an interest rate is not necessarily given. The expected
present value calculation can still be made, but it is an estimate because the
probabilities and other values that go into it are estimates.

9. Market value will be affected if the RRA information affects investors’ subjective
probabilities of states of nature. This could happen, for example, if the RRA
information shows an increase or decrease in the present values of proved
reserves. This information, while highly relevant, is not yet included in historical
cost-based financial statements. Consequently, RRA information may cause
investors to increase or decrease their subjective probabilities over states of
nature. This would affect their evaluations of future cash flows, their buy/sell
decisions, hence the market value of the firm.
It can be argued that firm value will not be affected by pointing out that the RRA
information may be perceived by investors as so unreliable that they ignore it.
10. Relevant information is information that enables investors to estimate the

present value of future receipts from an asset (or payments under a liability).
Reliable information is information that faithfully represents what it is supposed
to represent, is free from bias, and is verifiable by a third party.
When conditions are not ideal, the estimation of the present value of future firm
receipts (i.e., relevant information) requires specification of a set of states of
nature. The probabilities of these states are subjective, which means that they
must be estimated by the preparer. Also, an interest rate must be specified for
the discounting calculations. All of these procedures are subject to errors,
reducing representational faithfulness, and possible bias. Both of these
possibilities reduce reliability. Thus, relevant information tends to be unreliable.
Conversely, reliable information, such as the historical cost of a capital asset or

the face value of debt, tends to be low in relevance because this basis of
valuation involves no estimates of future receipts or payments. Since expected
future receipts and interest rates change over time, historical cost-based
valuations lose relevance.
Therefore, the accountant who tries to secure greater relevance must cope with
a larger and more complex set of states of nature and associated subjective
probabilities. However, this means less reliability. Consequently, these two

desirable characteristics of accounting information must be traded off, since an

increase in one leads to a decrease in the other.
11. Several reasons can be suggested why Suncor’s management has

reservations about RRA:
• The discount rate of 10% might not reflect Suncor’s cost of capital.
• Low reliability. RRA involves making a large number of assumptions and

estimates. While SFAS 69 deals with low reliability in part by requiring
end-of-period oil and gas prices to be used (rather than prices
anticipated when the reserves are expected to be sold), management
may feel that end-of-year prices bear little relationship to the actual net
revenue the company will receive in the future. Furthermore,
management may be concerned about low reliability of other estimates,
such as reserve quantities.
• Frequent changes in estimates. Conditions in the oil and gas market can
change rapidly, making it necessary for the firm to make frequent
changes in estimates.
• Investors may ignore. Investors may not understand the RRA

information. Even if they do, management may believe the RRA
information is so unreliable that investors will ignore it. If so, why prepare
it?
• Legal liability. Management may be concerned that if the RRA estimates

are not realized, the firm will be subject to lawsuits from investors.
Management’s reservations may be an attempt to limit or avoid liability.
12. a. Most industrial and retail firms regard revenue as earned at the point of
sale. This is usually the earliest point at which significant risks and rewards of
ownership pass to the buyer, the seller loses control of the items sold (i.e., title
passes to purchaser) and at which the amount of revenue can be determined
with reasonable reliability.

b. Under RRA, revenue is recognized when oil and gas reserves are
proven. This point in the operating cycle does not meet the IAS 18 criteria for
revenue recognition. Since the reserves are not sold, the significant risks and
rewards of ownership have not been passed on and title has not passed. Also,
the large number of revisions to estimates under RRA casts doubt on the
reliability of the amount of revenue recognized. Presumably, this is why RRA is
presented as supplementary information only.
Note: This question illustrates that the tradeoff between relevance and reliability
can be equivalently framed in terms of revenue recognition as well as balance
sheet valuation. In effect, balance sheet valuation is in terms of the debit side of
asset valuation whereas criteria for revenue recognition are in terms of the
credit side. The basic tradeoff is the same, however. In particular, it should be
noted that early revenue recognition increases relevance, even though it may
lose reliability.
13. a. From a balance sheet perspective under ideal conditions, inventory is

valued at current value. This could be the present value of expected future cash
receipts from sale, that is, value-in-use. Alternatively, if market value of the
inventory is available, it could be valued at its market value, that is, its fair value
(the 2 values would be the same if markets work reasonably well, as is the case
under ideal conditions). From a revenue recognition perspective, revenue is
recognized as the inventory is manufactured or acquired.
b. Cost basis accounting for inventory is due to lack of ideal conditions.

Then, current value may change prior to sale, reducing reliability. Accountants
must feel that the reduction in reliability outweighs the greater relevance of
current inventory value.
Historical cost accounting for inventories is not completely reliable, since firm
managers have some room to manage (i.e., bias) their reported profitability
through their choice of cost methods (FIFO, LIFO, etc.) and, if inventory is
written down under the lower-of-cost-and-market rule, through their estimate of

market. Furthermore, even the cost of inventories is not always reliable. For
example, what is the cost of inventory that is manufactured?
14. a.
600 600 600

PA0 = + + = 566.04 + 534.00 + 503.77 = $1,603.81
1.06 1.06 1.063
2
PA1 = 566.04 + 534.00 = $1,100.04
PA2 = $566.04
Sure Corp.
Balance Sheet
As at December 31, 2008
Cash (600 – 50) $550.00 Shareholders’ equity
Capital asset, at Capital stock $1,603.81
present value $1,100.04 Net income 96.23
Dividend (50.00)
$1,650.04 $1,650.04
Sure Corp.
Income Statement
For the year ended December 31, 2008
Accretion of discount (1,603.81 × .06) $96.23

b. Sure Corp.
Balance Sheet
Cash (550 + 600 + 33 – 50) $1,133.00 Shareholders’ equity
Capital asset, at Capital stock $1,603.81
present value 566.04 Retained earnings 95.23
$1,699.04 $1,699.04
Note: Cash includes $550 × .06 = $33 interest on opening cash balance.
Retained earnings calculated as $96.23 – 50 + 99.00 – 50 = $95.23
Sure Corp.
Income Statement
Accretion of discount (1,650.04 × .06) $99.00
c. Under ideal conditions, present value and market value are equal. This
is because of arbitrage.
Under real conditions, market values provide only a partial implementation of

fair value accounting. Because of incomplete markets, market values are not
available for all assets and liabilities. If market values are not available for all
assets and liabilities, fair value accounting based on market values cannot be
fully implemented. Instead, numerous estimates of fair value are needed.

d. The main reason is the difficulty of estimating future cash flows. Since,
under realistic conditions these estimates are subject to error and bias,
reliability is reduced.
Another reason arises from possible error and bias in the choice of interest rate
for discounting. However, the prime bank rate and central bank rate are
available as proxies.
Note: Difficulties in identifying states of nature and estimating their subjective

probabilities can also be mentioned. However, strictly speaking, these do not
apply here since the question assumes ideal conditions of certainty.
Low reliability does not necessarily mean that present value-based accounting
is not decision useful, since present values are high in relevance. These two
desirable characteristics of accounting information must be traded off.

15. a. P.V. Ltd.
Balance Sheet
As at End of First Year
Financial Asset Liabilities
Cash (note 1) $1,137.40 Bonds outstanding (note 3) $616.00
Capital Asset, at Shareholders’ Equity
present value (note 2) 2,200.00 Capital stock issued (note 4)
2,474.00
Net income (note 5) 247.40
$3,337.40 $3,337.40
Notes:
1. Cash = $1,210.00 revenue - 72.60 (605 × 0.12) interest paid on

bonds = $1,137.40
2. Book value of asset = PV end of year 1 = (2,000 + 420)/1.10 =

$2,200
3. Bonds outstanding = PV at end of year 1 = (72.60 int. yr. 2 +

principal due of 605)/1.10 = $616
4. Capital stock is issued in the amount of cost of asset less proceeds

of bonds:
72.60 72.60 + 605

3,100 − [ + ]
1.10 1.10 2
= 3,100 − (66 + 560)
= 3,100 − 626
= $2,474

5. Net income for year 1 calculated as $2,474 × .10 = $247.40
6. Purchase price of capital asset can be verified as:
1,210/1.10 + 2,000/(1.10)2 + 420/(1.10)2 = $3,100
b. Ideal conditions are unlikely to hold because:
• It is unlikely that future cash flows from the fixed asset can be
accurately forecast.
• It is unlikely that there is a single interest rate in the

economy, and interest rates may change over time.
c. If ideal conditions do not hold, expected income is likely to be different

than the amount calculated in part a of $247.40. When ideal conditions do
not hold it is likely that the amounts and/or timing of expected future cash
flows will change over the year. This gives rise to changes in estimates,
which will be reflected in net income for the year.
Another reason why net income may change from expected is that interest
rates may change, which would also change the present value of future cash
flows. The resulting change in present value will be reflected in net income
for the year.
16. a. Expected present value of asset on January 1, 2008 and 2009:
⎡ 700 900 ⎤ ⎡ 200 300 ⎤

PA0 = 0.3⎢ + 2 ⎥
+ 0.7 ⎢ +
⎣1.06 1.06 ⎦ ⎣1.06 1.06 ⎥⎦
2
= 0.3(660.38 + 801.00 ) + 0.7(188.68 + 267.00 )

= 0.3 × 1,461.38 + 0.7 × 455.68
= 438.41 + 318.98
= 757.39

900 300
PA1 = 0.3 × + 0.7 ×
1.06 1.06
= 0.3 × 849.06 + 0.7 × 283.02
= 254.72 + 198.11
= 452.83
Rainy Ltd.
Balance sheet
Cash (700 – 50) $650.00 Shareholders’ equity
Capital asset, at Capital stock (PA1) $757.39
present value 452.83 Retained earnings (395.44 – 50) 345.44
$1,102.83 $1,102.83
Rainy Ltd.
Income Statement
Expected net income (accretion of discount) (757.39 × .06) $45.44
Abnormal earnings
Expected cash flow (0.3 × 700) + (0.7 × 200) = (210 + 140) $350.00
Actual cash flow 700.00 350.00
Net income for the year $395.44
b. The main reason why the present value calculations become unreliable is that
objective state probabilities are not available. Consequently, subjective
probabilities must be assessed. However, these are subject to error, bias and
lack of verifiability. Consequently, they are low in reliability.

Other reasons include the lack of a single interest rate in the economy,
identifying the set of states of nature, and possible non-observability of the
state realization. All of these introduce additional sources of error, bias, and
lack of verifiability into the present value calculations, reducing reliability.
c. A main reason is incomplete markets. Then, income cannot be

measured by the change in the market values of the firm’s assets and liabilities.
Lacking complete markets, present values or other fair value estimates must be
used to value assets and liabilities. However, when market values are not
available, such calculations are low in reliability, resulting in major adjustments
to previous years’ estimates. If true net income existed, there would be no
adjustments.
In view of these problems, accountants have retained historical cost for major
asset and liability classes and adopted criteria of decision usefulness and full
disclosure.
17. a. Under ideal conditions, the amount paid for an asset equals its present
value:
100 200 100 50
PA0 = 0.6( + 2
) + 0.4( + )
1.06 1.06 1.06 1.06 2
= 0.6(94.34 + 178.00) + 0.4(94.34 + 44.50)
= 0.6 × 272.34 + 0.4 × 138.88
= 163.40 + 55.55
= 218.95
b. QC Ltd.
Statement of Net Income
For the Year ended December 31, 2009
Accretion of discount (232.08 ×0.6) $13.92

Abnormal earnings
Expected cash flow (0.6 × 200 + 0.4 × 50) 140.00
Actual cash flow (high state) 200.00 60.00
Net income for the year $73.92

Note: Calculation of accretion of discount requires QC Ltd. net worth as at end of

2008:
Capital stock (= cost of capital asset) $218.95
Net income 2008 (218.95 × .06) 13.13
Net worth, December 31, 2008 $232.08
c.
QC Ltd.
Balance Sheet
Current asset Capital stock $218.95
Cash (100 + 200 + 6) $306.00 Retained earnings
Capital asset, at Net income, 2008 $13.13

present value 0.00 Net income, 2009 73.92 87.05
$306.00 $306.00

18. Note: In this problem, state probabilities are not independent over time. Part c
of this question requires calculations not illustrated in the text.
a. The cost of the machine equals its present value as at time zero:
PV0 =
1
(0.75 × 1,000 + 0.25 × 3,000)
1.08
+
1
[0.25(0.60 × 1,000 + 0.40 × 3,000)+ 0.75(0.10 × 1,000 + 0.90 × 3,000)]
1.082
=
1
(750 + 750) + 1 2 [0.25(600 + 1,200) + 0.75(100 + 2,700)]
1.08 1.08
= 0.9259259 × 1,500 + 0.8573388(0.25 × 1,800 + 0.75 × 2,800 )
= 1,388.89 + 0.8573388(450 + 2,100)
= 1,388.89 + 2,186.21
= $3,575.10
1
PV1 = (0.6 × 1,000 + 0.4 × 3,000)
1.08
1
= (600 + 1,200)
1.08
1,800
= = $1,666.67
1.08
b. Conditional Ltd.
Income Statement for Year 1
(No major failure)
Accretion of discount (expected net income) $286.01

(3,575.10 × .08 = $286.01)

Abnormal earnings
Year 1:
Expected cash flows (0.75 × 1,000 + 0.25 × 3,000 ) 1,500.00
Actual cash flows 3,000.00 1,500.00
Year 2:
Original expected cash flows:
(0.75 × 2,800 + 0.25 × 1,800) 2,550.00
Revised expected cash flows resulting from
year 1 state realization:
(0.60 × 1,000 + 0.40 × 3,000) 1,800.00
Reduction in year 2 expected cash flows 750.00
Present value of reduction: (750/1.08) (694.44)
Net Income $1,091.57
c. Conditional Ltd.
Balance Sheet as at End of Year 1
(No major failure)
Cash $3,000.00 Capital Stock $3,575.10
Capital Asset, Retained Earnings
at present value 1,666.67 Net income
for the year 1,091.57
$4,666.67 $4,666.67

19. a. Present value at January 1, 2008:
7,000 6,000 5,000

+ +
1.10 1.10 2 1.10 3
= $15,078.89
Present value at January 1, 2009, based on revised estimates:
6,500 6,000
+
1.10 1.10 2
= $10,867.77
ABC Ltd.
Income Statement from
Proved Oil and Gas Reserves
For the Year Ended December 31, 2008
Accretion of discount (15,078.89 × 0.10) $1,507.89
Changes in estimates:
Shortfall in 2008 revenue
(7,000 - 6,500) ($500.00)
Increase in present value
of future revenue 1,280.99 780.99
$2,288.88
Increase in present value of future revenue is calculated as follows:
Revised present value, at January 1, 2009 $10,867.77
Original present value, at January 1, 2009:
6,000 5,000
+ = 9,586.78
1.10 1.10 2
Increase in present value of future revenues $ 1,280.99

b. Possible concerns arise from the low reliability of RRA estimates, and
include:
• Reserves quantities. The timing of extraction may differ from estimate.
• Changes in price and cost estimates. Due to the number of assumptions

about oil prices and costs in the RRA calculations, including use of year-end oil
and gas prices, the RRA estimated future cash flow amounts might not
reflect the amount of net revenue the firm will actually receive in future
periods. This may result in substantial changes to previous RRA information.
• Lawsuits. The standardized measure of future cash flows may not

represent fair market value of reserves. Management may fear this will mislead
investors, possibly leading to lawsuits.

20. a. FX Energy, Inc.
Income Statement for 2008
Expected net income—accretion of discount $546
Abnormal earnings:
Present value of additional reserves proved
during the year 2,511
Unexpected items-changes in estimates
Net changes in prices and production costs (159)
Changes in estimated future development
costs (53)
Revisions in previous quantity estimates (31)
Changes in rates of production and other 116 (127) 2,384
Net income from proved oil and gas reserves $2,930
b. RRA net income of $2,930 differs from the historical cost-based loss of
$7,245 because of differences in the timing of revenue recognition. Under
historical cost accounting, revenue is recognized when the reserves are lifted
and sold. Under RRA, revenue is recognized as reserves are proved. Then,
RRA net income consists of accretion of discount on the opening present value
of proved reserves, adjusted for abnormal earnings (i.e., corrections of opening
present value). For FX Energy, Inc., the main reason for the large abnormal
earnings is the proving of $2,511 of additional reserves during the year. Under
historical cost accounting, this amount is not yet recognized as revenue.
c. The reason derives from concerns about reliability of the reserves

estimates. Information about all reserves, and their expected future cash flows,
would be highly relevant. However, the designers of SFAS 69 must have felt
that the low reliability of this information would outweigh the increased
relevance. That is, unproved reserves, and actual oil and gas prices at the time

these reserves are expected to be lifted and sold, can not be determined with
sufficient reliability that the resulting estimates are decision useful.
d. Again, the reason derives from reliability concerns. Allowing each firm to
choose its own discount rate opens up the possibility of manager bias, whereby
the rate is chosen to achieve a desired present value.
A disadvantage is that when conditions are not ideal, different firms may have
different costs of capital. This can arise, for example, from operating in different
countries and in different geographical conditions. Then, relevance is
decreased since the reserves’ present value at 10% will not reflect the
riskiness, hence the required rate of return, of those reserves.
21. a. Moonglo Energy Inc.

Income Statement for Proved Oil and Gas Operations
For year 2008
RRA Basis
Accretion of discount $125

Present value of additional reserves added during year (162 – 4) 158
Unexpected items: Changes in previous year’s estimates 134
Net income from proved reserves for the year $417
b. Profit on a historical cost basis differs from RRA net income because of
different bases of revenue recognition. Under RRA, income is recognized as
reserves are proved. Under historical cost, income is recognized as sales are
made. Since proving of reserves precedes sales, the two income measures will
differ. Here, since the standardized measure increased for the year, RRA net
income exceeds historical cost net income.

c. RRA is more relevant, since it records revenue earlier than historical

cost. This gives the financial statement user an earlier reading of future firm
performance.
If a balance sheet was prepared on an RRA basis, inventory of proved oil and
gas reserves would be valued at year-end selling prices rather than at historical
cost. Again, this is more relevant since selling price of inventory gives a better
measure of future firm performance than historical cost, assuming reasonable
reliability.
Note: Either a revenue or a balance sheet approach to relevance is acceptable.
RRA is less reliable than historical cost, since changes to estimates are usually
required. RRA estimates are subject to error both because of difficulties and
possible errors in estimating amounts of reserves and their production and
development costs, and the possibility of manager bias. Here, changes to
estimates ($134) exceed expected net income for the year ($125).
Furthermore, it is not clear that different persons would come up with the same
proved reserves estimates, so that verifiability is suspect.
22. a. The most relevant point of revenue recognition is at the beginning of the
operating cycle. For a manufacturing firm, this would be as raw materials and
other components of manufacturing cost are acquired and production begins.
For an oil and gas firm, this would be as reserves are discovered. For a retail
firm, this would be as merchandise is acquired. For a firm with long-term
contracts, this would be when the contract is signed.
Indeed, one could envisage revenue recognition even earlier than this. For
example, for a manufacturing firm, revenue could be recognized when
acquisition of manufacturing capacity begins, consistent with accounting under
ideal conditions.

The most reliable point of revenue recognition is as cash is collected from sales
and services.
b. Points to be considered:
• Lucent has an incentive to recognize 2000 revenue early to prevent its

reported net income from falling below its 1999 level.
• The earlier revenue is recognized, the greater the relevance.
• Early revenue recognition sacrifices reliability, since amounts and timing

of cash collections become more difficult to predict.
• It appears that the significant risks of ownership have not been

transferred to the buyer with respect to merchandise shipped to
distribution partners and subsequently returned.
• Revenue recognition on partial shipments may violate the conventional

point of sale criterion. However, if these shipments are part of a long-
term contract, revenue recognized as goods are shipped may be
consistent with the criterion of revenue recognition on a percentage of
completion basis.
• Lucent’s treatment of vendor financing appears to contradict the criteria.

While, technically, products may have been sold, credits granted to
assist the customer to finance purchases reduce assurance about the
amounts that will ultimately be collected.
A reasonable conclusion is that Lucent has been overly aggressive in

recognition of revenue. The necessity to restate 2000 revenue suggests that
the significant risks and rewards of ownership had not been transferred to the
buyer and that effective control of items shipped had not been relinquished.
c. Ownership interest in the customer increases problems of reliability. The

vendor’s revenue will be biased upwards if it uses its influence to force goods

and services on the customer beyond the point where the customer can sell
and pay for the goods and services in the normal course of business. This
appears to have happened in the case of Lucent in 2000.
23. a. Relevant information is information that enables the prediction of future

firm performance, such as future cash flows. Early revenue recognition
anticipates these future cash flows, hence it is relevant. Thus, Qwest’s revenue
recognition policy provided relevant information.
b. Reliable information is information that is representationally faithful,

unbiased and verifiable. When significant risks and rewards of ownership are
transferred to the buyer and the seller loses effective control, the amount of
future cash flows is determined with reasonable representational faithfulness
and verifiability, since the purchaser has an obligation to pay. Also, if the
amount of cash to be received is determined in an arms-length transaction, the
amount of sale is free of bias.
It seems that Qwest’s revenue recognition policy met none of these reliability
criteria. The future cash flows were not representationally faithful since there
appeared to be no provision for returns, obsolescence, or unforeseen service
costs. Furthermore, as evidenced by the later SEC settlements, substantial
manager bias is apparent. Obviously, revenue amounts were not verifiable,
since the SEC came up with materially different valuations.
c. Under ideal conditions, revenue is recognized as production capacity is

acquired, since future revenues, or expected revenues, are inputs into the
present value calculations. For an oil and gas company, revenue recognition is
analogous—revenue is recognized as reserves are discovered or purchased.
The reason is that under ideal conditions, future cash flows, or expected future
cash flows, are perfectly reliable. There is thus no sacrifice of usefulness in
recognizing revenue as early as possible.
Note: A superior answer will point out that under ideal conditions net income
consists of interest on opening present value (i.e., accretion of discount), plus

or minus abnormal earnings under ideal conditions of uncertainty). This is not

operating revenue, however, but simply an effect of the passing of time.
24. a. The National Instrument 51-101 disclosures are more relevant than
those of SFAS 69. Reasons include:
• Information about probable reserves is given in addition to information

about proved reserves.
• Future revenues are evaluated using forecasted prices as well as year-

end prices. SFAS 69 uses only year-end prices.
• Unlike SFAS 69, future net revenues are discounted at several different
interest rates. This allows the investor to choose that rate closest to
his/her estimate of the firm’s cost of capital. This rate could vary, for
example, due to location of reserves or current interest rates in the
economy.
b. The National Instrument 51-101 disclosures seem reasonably reliable.

Reasons include:
• A precise definition of proved reserves and unproved reserves. This

adds to representational faithfulness.
• Reserves information must be verified by a qualified independent

professional and reviewed by the Board of Directors. This adds to
representational faithfulness and verifiability.
• A counterargument is that the required estimates of unproved reserves

are less reliable, by definition, than proved reserves. Disclosures of only
proved reserves avoids this source of unreliability.
• An additional counterargument is that by their nature, estimates of future

oil and gas prices are subject to error and possible bias. Note, however,
that volatility of prices per se is not a source of unreliability.

c. Reasons for the disclaimer:
• Western Oil Sands may be concerned about the reliability of its

estimates, despite our conclusion in b that these are reasonably reliable.
• Western Oil Sands may be concerned that if future revenues differ from
those forecasted in its AIF, it may be subject to lawsuits. The disclaimer
should help defend against such suits.
• Managers may be concerned that their reputations will be adversely

affected if future revenues differ from forecast. The disclaimer should
help protect their reputations.
25. a. A theoretically correct measure of income is the net income of a firm for
a period calculated on a present value basis; that is, accretion of discount on
opening firm present value, plus or minus any differences between expected
and actual cash flows for the period.
Alternatively, net income is theoretically correct if it is calculated so as to

include the changes during the period in the market values of all assets and
liabilities, adjusted for capital transactions (providing that the markets for assets
and liabilities work reasonably well).
b. A theoretically correct measure of income does not exist because ideal

conditions do not exist. As a result, future cash inflows and outflows from
assets and liabilities cannot be reliably estimated. This means that present
value-based net income is not theoretically correct since theoretical correctness
requires complete reliability.
Furthermore, market incompleteness can exist in the absence of ideal

conditions. Then, properly working market values for all assets and liabilities of
a firm need not exist. As a result, net income based on net changes in market
values is not theoretically correct either.

c. Historical cost accounting is reasonably reliable because the cost of an

asset is usually an objective and verifiable number. However, while cost is also
relevant at time of acquisition, it may lose relevance over time due to changes
in market prices, interest rates and economic conditions, which will change the
asset’s fair value. However, adjustment of the asset to its new fair value
reduces reliability since properly working market values may not exist and/or
future cash flows are difficult to estimate reliably. In effect, attempts to increase
relevance will generally reduce reliability, and vice versa. Since historical cost
accounting does not adjust for changes in fair value, it trades off considerable
relevance to attain reasonable reliability.
A similar argument applies to liabilities. For example, the carrying value of debt
is not usually adjusted for changes in interest rates. Since interest rates are
volatile, adjustment of debt to fair value reduces reliability, although fair value is
more relevant. Again, historical cost accounting for debt trades off relevance for
reliability.
d. Problems associated with historical cost accounting:
• Amortization of capital assets must be deducted from revenue to

calculate historical cost-based net income. Since a correct measure of
amortization, that is, change in present value of future cash flows or
change in fair value, is not sufficiently reliable to warrant this basis of
accounting, cost-based amortization is used in practice. But there is no
unique cost-based amortization method. This reduces comparability of
reporting. Also, managers might manipulate a firm’s reported profitability
by their choice of amortization methods, thus eroding the reliability of
accounting numbers.
SE versus FC accounting in the oil and gas industry. The number of estimates and
assumptions involved in these procedures can be quite large, leading to possible error
and bias. As a result, firms use historical cost accounting for the costs of oil and gas
exploration in the financial statements proper. But the matching principle of historical

cost accounting can be used to justify either FC or SE. This complicates the
comparison of earnings of oil and gas companies.
Additional Problems
2A-1. Note: In this problem, state probabilities are not independent over time.
XYZ Ltd. purchased an asset on January 1, 2005 with a useful life of two years,
at the end of which time it has no residual value. The cash flows from the asset
are uncertain. If the economy turns out to be “normal,” the asset will generate
$4,000 in cash flow each year; if the economy is “bad,” it will generate $3,000 in
cash flow per year; and if the economy is “good,” the cash flow generated will
be $5,000 per year. Cash flows are received at year-end. In each year, the
chances of a “normal” economy being realized are 30%, the chances of a “bad”
economy are 50%, and the chances of a “good” economy are 20%. State
realization for both years becomes publicly known at the end of 2005, that is, if
the normal state happens for year 1, it will also happen for year 2, etc.
Assumptions
• Ideal conditions hold under uncertainty.
• The economy-wide interest rate is 10%.
XYZ Ltd. finances the asset purchase partly by a bond issue and partly
by a common share issue. The bond has a $3,000 face value and a 10%
coupon rate and matures on December 31, 2001.
• XYZ Ltd. has adopted the policy of paying out 50% of its net income as
dividends to its shareholders.
• The economy turns out to be “good.”

Required
a. Calculate the present values of the asset at January 1, 2005, and

December 31, 2005.
b. Prepare the present value-based income statement of XYZ Ltd. for the
year ended December 31, 2005.
c. Prepare the present value-based balance sheet of XYZ Ltd. as at

December 31, 2005.
d. Explain why, even under uncertainty, present value-based financial

statements are both relevant and reliable provided ideal conditions hold.
e. Explain why shareholders of XYZ Ltd. are indifferent to whether they

receive any dividend from the company.
2A-2. Relevant Ltd. operates under ideal conditions of uncertainty. Its operations are
highly dependent on the weather. For any given year, the probabilities are 0.3
that the weather will be bad and 0.7 that it will be good. These state
probabilities are independent over time. That is, the state probabilities for a
given year are not affected by the actual weather in previous years.
Relevant Ltd. produces a single product for which the demand will fall to zero at
the end of 2 years. It produces this product using specialized machinery, which
will have no value at the end of 2 years. The machinery was purchased on 1
January, 2005. It was financed in part by means of a bank loan of $2,000
repayable at the end of 2006, with the balance financed by capital stock. No
dividends will be paid until the end 2006. Interest on the bank loan is payable at
the end of each year. The interest rate in the economy is 6%.
Cash flows are not received until the end of each year. Amounts of cash flows
for each year are given in the following payoff table:

Cash Flow Cash Flow
State Probability Year 1 Year 2
Bad weather 0.3 $600 $400
Good weather 0.7 $6000 $3000
State realization for 2005 is good weather.
Required
a. Prepare, in good form, a balance sheet for Relevant Ltd. as at the end of
2005 and an income statement for 2005.
b. As at January 1, 2006, how much is expected net income for 2006?
c. Explain why the financial statements you have prepared in part a are
both completely relevant and completely reliable.
2A-3. An area where discounting could possibly be applied is for future income tax
liability resulting from timing differences. Consider a firm that purchases an asset
costing $100,000 on January 1 of year 1. It is amortized on a straight-line basis at
20% per year on the firm’s books. Tax amortization is 40% on a declining - balance
basis. The income tax rate is 45%.
The following schedule shows a simplified calculation of the income tax liability
balance for this asset over its life, assuming zero salvage value. This is the firm’s only
capital asset.

Straight-
Opening Tax Line
Year Tax B.V. Additions Amortization Amortization Difference
1 — $100,000 $40,000 $20,000 $20,000
2 60,000 24,000 20,000 4,000
3 36,000 14,400 20,000 (5,600)
4 21,600 8,640 20,000 (11,360)
5 12,960 12,960* 20,000 (7,040)
Tax on Income Tax
Year Difference Liability
1 9,000 9,000
2 1,800 10,800
3 (2,520) 8,280
4 (5,112) 3,168
5 (3,168) 0
*It is assumed that all of the remaining tax book value is claimed in year 5.
Required
a. Calculate the discounted present value of the future income tax liability
at the end of each of years 1 to 5. Use a discount rate of 12%.
b. Why are the balances calculated in part a different from the

undiscounted income tax liabilities?
c. What problems would there be if the discounting approach was applied

to the tax liability of a large, growing firm with many capital assets?

2A-4. On January 1, 2005, GAZ Ltd. purchased a producing oil well, with an
estimated life of 15 years, and started operating it immediately. The
management of GAZ Ltd. calculated the present value of future net cash flows
from the well as $1,500,000. The discount rate used was 10%, which is the
company’s expected return on investment. During 2005, GAZ Ltd. recorded
cash sales (net of production costs) of $600,000. GAZ Ltd. also paid $50,000
cash dividends during 2000.
Required
a. Prepare the income statement of GAZ Ltd. for the year ended December
31, 2005, using RRA.
b. Prepare the balance sheet of GAZ Ltd. as at December 31, 2005, using
RRA.
c. Summarize the perceived weaknesses of RRA accounting.
d. Why does SFAS 69 require that a 10% discount rate should be used by
all oil and gas firms rather than allowing each firm to select its own discount
rate?
Suggested Solutions to Additional Problems
2A-1. a. Expected present value of asset on January 1, 2005:
⎛ 3,000 3,000 ⎞ ⎛ 4,000 4,000 ⎞ ⎛ 5,000 5,000 ⎞

0.50 ⎜ + 2 ⎟
+ 0.30 ⎜ + 2 ⎟
+ 0.20 ⎜ + 2 ⎟
⎝ 1.10 1.10 ⎠ ⎝ 1.10 1.10 ⎠ ⎝ 1.10 1.10 ⎠
= $2,603.31 + 2,082.65 + 1,735.54
= $6,421.50

Expected present value of asset on December 31, 2005, given “good”

economy:
5,000/1.10 = $4,545.45
Note: PV of bonds payable = $3,000 (equal to face value because market

interest rate equals coupon rate)
b.
XYZ Ltd.
Income Statement
Accretion of discount [(6,421.50 – 3,000) × .10] $342.15

$5,000.00
Abnormal earnings
Actual cash flow, 2005 $5,000,00
Expected cash flow, 2005
(4,000 × 0.30 + 3,000 × 0.50 + 5,000 × 0.20) 3,700.00 1,300.00
Expected cash flow 2006, at Dec. 31, 2005 5,000.00
Expected cash flow 2006, at Jan. 1, 2005 3,700.00
1,300.00
Present value at Dec. 31, 2005 1,300/1.10 1,181.80
Net income $2,823.95

c. XYZ Ltd.
Balance Sheet
Financial Asset Liabilities
Cash (note 1) $3,288.02 Bonds payable $3,000.00
Capital Asset, Shareholders’ Equity
At present value 4,545.45 Opening balance 3,421.50
Retained earnings (note 2) 1,411.97
4,833.47
$7,833.47 $7,833.47
Notes:
1. Cash = revenues (5,000.00) - interest expense (300.00) - dividends

(1,411.98 (1/2 of net income of 2,823.95))
2. Retained earnings = net income (2,823.95) - dividends (1,411.98)
d. Present value-based financial statements under ideal conditions of

uncertainty are relevant because balance sheet values are based on expected
future cash flows and dividend irrelevancy holds.
They are reliable because present value calculations are representationally

faithful, free of bias, and verifiable. That is, since all states of nature are
identified and have known, objective probabilities, the state realization is
observable, and the economy-wide interest rate is known, present value
calculations are precisely represent asset and liability values, cannot be biased
by managers, and are vervifable by a second party.

e. Investors are indifferent across dividend policies under ideal conditions

because cash retained and dividends distributed to investors earn the same
known rate of return. Thus, regardless of the firms’ dividend policy, investors’
total wealth (the sum of dividends and value of share holdings in the firm) is
independent of that dividend policy. Amounts not paid out as dividends remain
within the firm and earn the same rate of return for the shareholders.
2A-2. a. First, calculate the cost of the specialized machinery at 1 Jan., 2005:
PA0 = 1/1.06[0.3 × 600 + 0.7 × 6000] + 1/(1.06)2[0.3 × 400 + 0.7 × 3000]
= .9434[180 + 4200] + .8900[120 + 2100]
= 4132.09 + 1975.80
= $6,107.89
Next, calculate the value of the machinery as at 1 Jan., 2006:
PA1 = 1/1.06[0.3 × 400 + 0.7 × 3000]
= .9434[120 + 2100]
= $2,094.35
Relevant Ltd.
Balance Sheet
As at 31 December, 2005
Assets Liabilities and Shareholders’ Equity
Cash (6,000-120) $5,880.00 Bank Loan $2,000.00
Capital Asset, at Shareholders’ Equity

present value 2,094.35 Capital Stock $4,107.89
Retained
Earnings 1,866.46 5,974.35
$7,974.35 $7,974.35

Relevant Ltd.
Income Statement
For the Year Ended 31 December, 2005
Expected Net Income [6,107.89 – 2,000 × .06] $246.46
Abnormal earnings
Actual Cash Flow 6,000.00
Expected Cash Flow
(600 × 0.3 + 6,000 × 0.7) 4,380.00 1,620.00
Net Income $1,866.46
b. Expected net income for 2006, evaluated as at 1 Jan., 2006 is:
$5,974.35 × .06 = $358.46
c. The financial statements are completely relevant because they are

based on the expected present value of future cash flows. Thus they give
complete information to investors about the firm’s future economic prospects.
They are completely reliable because the assumption of ideal conditions
(essentially, that the set of possible states of nature, cash flows resulting from
each state, and objective probabilities of the states, are publicly known) means
that financial statement items are representationally faithful, free of bias, and
verifiable.
2A-3. a. The discounted PV of the future income tax liability:
At the end of year 1
1,800 2,520 5,112 3,168

PA1 = − − −
1.12 1.12 2 1.12 3 1.12 4
= ($6,053.73)

2,520 5,112 3,168

PA2 = − − −
1.12 1.12 2 1.12 3
= ($8,580.17)
5,112 3,168
PA3 = − −
1.12 1.12 2
= ($7,089.80)
3,168
PA4 = −
1.12
= ($2,828.57)
PA5 = 0
b. It is because the balances calculated in part a are discounted to reflect

the PV of the future repayments of tax. This reduces their amounts.
c. i) Repayment of the future income tax liability is triggered when capital

cost allowance falls below book amortization. Depending on the rate and time
pattern of the growth of capital assets, the future income tax liability may never
have to be actually repaid or, at least, the repayment could be postponed
indefinitely. This would happen if the pool of capital assets grows sufficiently
each year that capital cost allowance is always greater than straight-line
amortization.

ii) It is not clear what interest rate should be used for the discounting. A
risk-free rate, the firm’s borrowing rate, or cost of capital are possible
alternatives.
iii) Under the liability view of income tax timing differences, the future income
tax liability has to be adjusted for changes in the tax rate. Thus, for a
completely relevant present value calculation, changes in tax rates, and the
timing of such changes, would need to be anticipated. Lacking such
anticipation, the future income tax liability would have to be adjusted as tax
rates change. This would require considerable cost and effort, and would
introduce volatility into reported net income.

2A-4. a. PV of future net cash flows, January 1, 2005 $1,500,000
Less net sales during 2005 600,000
900,000
Accretion of discount (10% of 1,500,000) 150,000
PV December 31, 2005 $1,050,000
GAZ Ltd.
Income Statement
Accretion of discount (1,500,000 × .10) $150,000
b. GAZ Ltd.
Balance Sheet
Cash (600,000 - 50,000) $550,000 Opening balance $1,500,000
Capital Asset
Reserves, at Retained earnings
estimated P.V. 1,050,000 (150,000 - 50,000) 100,000
$1,600,000 $1,600,000

c. Weaknesses of RRA:
• The mandated discount rate of 10% might not reflect the actual risk and
return for GAZ Ltd. This reduces relevance.
• RRA involves making a large number of assumptions and estimates, with

respect to quantities and timing of their extraction. As a result, estimated
future RRA cash flows may bear little relationship to the net revenue the
company will receive in the future. This reduces relevance.
• Frequent, material changes in estimates reduce the reliability of the RRA

values.
• RRA requires year-end oil and gas prices, rather than prices
expected when it is anticipated the reserves will be lifted and sold. This
reduces relevance (although, it increases reliability).
d. Use of a single 10% rate was mandated in SFAS 69 to improve

comparability across firms and over time for the same firm. The effect is to
decrease relevance, since firms cannot choose a discount rate most suitable to
their own riskiness and cost of capital. However, reliability is increased since
management cannot bias the present value calculations by its choice of
discount rate.

Scot ch02 Im

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Scot ch02 Im

Uploaded by

Copyright:

Available Formats

Instructor’s Manual—Chapter 2

Accounting Under Ideal Conditions

2.2 The Present Value Model Under Certainty

2.3 The Present Value Model Under Uncertainty

2.4 Reserve Recognition Accounting (RRA)

2.4.1 An Example of RRA

2.4.3 Critique of RRA

2.5 Historical Cost Accounting Revisited

2.5.1 Comparison of Different Measurement Bases

2.6 The Non-Existence of True Net Income

2.7 Conclusion to Accounting Under Ideal Conditions

Copyright © 2009 Pearson Education Canada 8

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES

1. To Appreciate the Concept of Ideal Conditions

2. To Use the Present Value Model Under Ideal Conditions to Prepare an

3. To Critically Evaluate Reserve Recognition Accounting (RRA) as an

Copyright © 2009 Pearson Education Canada 9

4. To Interrelate Basic Accounting Concepts

Historical cost accounting is presented as a compromise between cash accounting

Copyright © 2009 Pearson Education Canada 10

5. To Question the Existence of Net Income as a Well-Defined Economic

Copyright © 2009 Pearson Education Canada 11

SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS

Income Statement for Year 2

Accretion of discount (10% × 286.36) $28.64

Financial Asset Shareholders’ Equity

Cash $315.00 Opening balance $286.36

Net income 28.64

Present value 0.00

Copyright © 2009 Pearson Education Canada 12

Accretion of discount (10% × 276.36) $27.64

P.V.’s balance sheet at time 2 would be:

Financial Asset Shareholders’ Equity

Cash: (140 + 14 + 150) $304.00 Opening balance: $276.36

(286.36 - 10.00 dividend)

Capital Asset, at Net income 27.64

Present value 0.00

Thus, at time 2 the shareholders have:

Cash from dividend $10.00

Interest at 10% on cash dividend, for year 2 1.00

Value of firm per balance sheet 304.00 $315.00

Copyright © 2009 Pearson Education Canada 13

0.50 (-23.97) + 0.50 (76.03)

236.36 × .10 = 23.64

336.36 × .10 = 33.64,

Copyright © 2009 Pearson Education Canada 14

including interest income of $20 on opening cash balance.

0.50 (23.64) + 0.50 (33.64)

Note: further discussion of accretion of discount would bring out:

The amount of accretion of discount is driven by the principle of arbitrage, and

Copyright © 2009 Pearson Education Canada 15

(good economy in year 2)

Accretion of discount [(336.36 – 40) ×.10] 29.64

Abnormal earnings, as a result of good state

realization in year 2 (200 – 150) 50.00

Net income year 2 $79.64

P.V.’s balance sheet at the end of year 2 will then be:

Financial Asset Shareholders’ Equity

Cash (200 - 40 + 200 + 16) $376.00 Opening balance $336.36

Less: Dividend end

Capital Asset 0.00 of year 1 40.00

Add: Net income 79.64